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Founder beware: the risks of seeking investment via crowdfunding

18 November 2015

This article was originally published on AltFi News, a leading news and analysis service for the alternative finance industry, on 3 November 2015.

Introduction

Crowdfunding looks like the entrepreneur's best friend.

Seeking investment used to involve trawling banks, angels and VCs. This was a gruelling process. It involved thorough preparation, challenging questions and, more often than not, painful rejection. With crowdfunding you can put a pitch on a platform and wait for the cash to start rolling in. Happy days.

Importantly valuations also appear to be generous at present - in a low interest rate environment investors are keen to find a good return on their cash. This means that companies can raise decent chunks of capital without having to sell too much of their business. The government tax incentives of SEIS and EIS may also be fuelling this trend by effectively subsidising the prospective investor return.

Could it be too good to be true?

Advantages

There is no denying that crowdfunding can be a major help to start-up businesses. The main advantage, of course, is access to finance. Crowdcube alone has raised £100 million and funded 290 businesses. Crowdfunding can mean serious money.

Crowdfunding also has marketing benefits. People who invest in a business via crowdfunding are often supportive of the aims and products of the business and are often consumers, or potential consumers, of the very product that the funding company sells. As such they are potential customers and could well be enthusiastic ambassadors for the business in which they have invested. In such a way even if people don't invest, then the crowdfunding process can still be a good PR exercise. And those who do invest are likely to advocate the merits of the product to friends and colleagues.

The fact that many crowdfunding investors will know something about the markets of the businesses in which they invest means that there can also be market research advantages. If you want to road-test a new product then crowdfunding investors may be a good place to start.

However, while crowdfunding undoubtedly has very considerable upsides, it is not without its risks.

Rewards, shares or debt?

Some crowdfunding opportunities simply offer "rewards" in exchange for cash. These rewards might include tickets to launch parties or discounts on products offered by the relevant businesses. There are few risks to this approach; but the value of investment is often small too. In most case the reward is simply a pre-sale of the product.

If you want to attract bigger investment you probably need to offer shares or debt. That is where things can get complicated.

Investments

If the platform is asking you to offer shares in your company then there are some basic issues to examine. For a start, private companies cannot generally offer their shares to the public (subject to certain exemptions). How does the platform address this? Another consideration is that shareholders have certain rights over the businesses that they own. Does the platform provide a sensible way of managing this?

If you are being asked to issue debt then you should be asking how the debt will be documented and what your obligations will be.

Promotions

There are strict rules governing the ways in which businesses can offer investment opportunities to the public. Breaching these rules can be a criminal offence. How does the platform approach this issue?

Forward looking statements

Promoting a business will inevitably mean making statements regarding the future performance of that business. Here, again, there are important risks to bear in mind. Entrepreneurs must not make misrepresentations regarding their businesses. Clearly an outright lie could amount to fraud and lead to criminal liability punishable by up to ten years in prison and a fine (there is no limit to the size of fine that the court could impose).

Misrepresentations made without the intention to deceive are still serious matters. An entrepreneur who tries to attract investment by making statements while being reckless as to whether or not they are true (and without making proper enquiries) could be liable for fraudulent or negligent misrepresentation. If investors lose money as a result they may try to recover this from the person who made the statement. It is important to be confident in the basis for, and wording of, any promotional materials that are sent to investors.

The platform's role

The platform's role is essential to arranging investments in various businesses. This may mean that they should be authorised by the Financial Conduct Authority. If they are not authorised by the FCA it is worth asking why they are not.

Who does what?

The platform and the business will have to work closely and it is important to establish who will be doing what.

Marketing materials are a good example of this. The business will probably be responsible for the content of marketing materials (and the directors will have fiduciary duties in this regard) but the platform may be responsible for distributing them. Does the platform have the right to edit the materials that it distributes? Who has final sign-off on how the materials actually look? How quickly can mistakes be corrected?

It is important that responsibility and control are closely aligned. If investors or the courts will hold the business responsible for something then the business will generally wish be in control of it.

Next steps

Crowdfunding may get a business off the ground but you are likely to need further injections of finance later on. This may mean approaching VCs. Venture capitalists will be pleased to see a business that has won support and capital from the crowd. They may be less pleased to see a large collection of small shareholders. How would you transition the business away from its crowdfunded roots?

Conclusion

Crowdfunding plays a great and growing role in corporate finance. Many businesses, investors, and of course, the platforms themselves will make money as a result of crowdfunding. It is important, however, not to get swept along by the hype.

Seeking investment via a crowdfunding platform may well be productive but it is not a risk-free activity. Any start-up considering this route should go into it with their eyes open - and be prepared to ask a lot of questions.


NOT LEGAL ADVICE. Information made available on this website in any form is for information purposes only. It is not, and should not be taken as, legal advice. You should not rely on, or take or fail to take any action based upon this information. Never disregard professional legal advice or delay in seeking legal advice because of something you have read on this website. Gowling WLG professionals will be pleased to discuss resolutions to specific legal concerns you may have.

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